Determinants of Aggregate Demand
in an Open Economy
To analyze how output is determined in the short run when product prices are sticky, we
introduce the concept of aggregate demand for a country’s output. Aggregate demand is
the amount of a country’s goods and services demanded by households and firms throughout
the world. Just as the output of an individual good or service depends in part on the
demand for it, a country’s overall short-run output level depends on the aggregate demand
for its products. The economy is at full employment in the long run (by definition) because
wages and the price level eventually adjust to ensure full employment. In the long run,
domestic output therefore depends only on the available domestic supplies of factors of
production such as labor and capital. As we will see, however, these productive factors can
be over- or underemployed in the short run as a result of shifts in aggregate demand that
have not yet had their full long-run effects on prices.
In Chapter 13 we learned that an economy’s output is the sum of four types of expenditure
that generate national income: consumption, investment, government purchases, and the current
account. Correspondingly, aggregate demand for an open economy’s output is the sum of
consumption demand ( ), investment demand ( ), government demand ( ), and net export
demand, that is, the current account (CA). Each of these components of aggregate demand
depends on various factors. In this section we examine the factors that determine consumption
demand and the current account. We discuss government demand later in this chapter
when we examine the effects of fiscal policy; for now, we assume that is given. To avoid
complicating our model, we also assume that investment demand is given. The determinants
of investment demand are incorporated into the model in the Online Appendix to this chapter.
Determinants of Consumption Demand
In this chapter we view the amount a country’s residents wish to consume as depending on
disposable income, (that is, national income less taxes, ).1 ( , and are all
measured in terms of domestic output units.) With this assumption, a country’s desired
consumption level can be written as a function of disposable income:
C = C(Yd).
Yd Y - T C, Y T
G
C I G
CHAPTER 17 Output and the Exchange Rate in the Short Run 423
Because each consumer naturally demands more goods and services as his or her real
income rises, we expect consumption to increase as disposable income increases at the
aggregate level, too. Thus, consumption demand and disposable income are positively
related. However, when disposable income rises, consumption demand generally rises by
less because part of the income increase is saved.
Determinants of the Current Account
The current account balance, viewed as the demand for a country’s exports less that
country’s own demand for imports, is determined by two main factors: the domestic currency’s
real exchange rate against foreign currency (that is, the price of a typical foreign
expenditure basket in terms of domestic expenditure baskets) and domestic disposable
income. (In reality, a country’s current account depends on many other factors, such as
the level of foreign expenditure, but for now we regard these other factors as being held
constant.)2
We express a country’s current account balance as a function of its currency’s real
exchange rate, , and of domestic disposable income, :
As a reminder of the last chapter’s discussion, note that the domestic currency prices of
representative foreign and domestic expenditure baskets are, respectively, and ,
where (the nominal exchange rate) is the price of foreign currency in terms of domestic
currency, is the foreign price level, and is the home price level. The real exchange
rate , defined as the price of the foreign basket in terms of the domestic one, is therefore
. If, for example, the representative basket of European goods and services costs
the representative U.S. basket costs $50 ( ), and the dollar/euro exchange rate
is $1.10 per euro ( ), then the price of the European basket in terms of U.S. baskets is
Real exchange rate changes affect the current account because they reflect changes in
the prices of domestic goods and services relative to foreign goods and services. Disposable
income affects the current account through its effect on total spending by domestic consumers.
To understand how these real exchange rate and disposable income effects work, it
is helpful to look separately at the demand for a country’s exports, EX, and the demand for
imports by the country’s residents, IM. As we saw in Chapter 13, the current account is
related to exports and imports by the identity
when CA, EX, and IM all are measured in terms of domestic output.
CA = EX - IM,
= 0.88 U.S. baskets/European basket.
EP*/P =
(1.10 $/€) * (40 €/ European basket)
(50 $/U.S. basket)
E
€40 (P*), P
EP*/P
q
P* P
E
EP* P
CA = CA(EP*/P, Yd).
q = EP*/P Yd
2 In Chapter 19 we study a two-country framework that takes account of how events in the domestic economy
affect foreign output and how these changes in foreign output, in turn, feed back to the domestic economy. As the
previous footnote observed, we are ignoring a number of factors (such as wealth and interest rates) that affect
consumption along with disposable income. Since some part of any consumption change goes into imports, these
omitted determinants of consumption also help to determine the current account. Following the convention of
Chapter 13, we are also ignoring unilateral transfers in analyzing the current account balance.
424 PART THREE Exchange Rates and Open-Economy Macroeconomics
How Real Exchange Rate Changes Affect the Current Account
You will recall that a representative domestic expenditure basket includes some imported
products but places a relatively heavier weight on goods and services produced domestically.
At the same time, the representative foreign basket is skewed toward goods and
services produced in the foreign country. Thus a rise in the price of the foreign basket in
terms of domestic baskets, say, will be associated with a rise in the relative price of foreign
output in general relative to domestic output.3
To determine how such a change in the relative price of national outputs affects the current
account, other things equal, we must ask how it affects both EX and IM. When rises,
for example, foreign products have become more expensive relative to domestic products:
Each unit of domestic output now purchases fewer units of foreign output. Foreign consumers
will respond to this price shift by demanding more of our exports. This response by foreigners
will therefore raise EX and will tend to improve the domestic country’s current account.
The effect of the same real exchange rate increase on IM is more complicated. Domestic
consumers respond to the price shift by purchasing fewer units of the more expensive foreign
products. Their response does not imply, however, that IM must fall, because IM
denotes the value of imports measured in terms of domestic output, not the volume of foreign
products imported. Since a rise in tends to raise the value of each unit of
imports in terms of domestic output units, imports measured in domestic output units may
rise as a result of a rise in even if imports decline when measured in foreign output
units. IM can therefore rise or fall when rises, so the effect of a real exchange rate
change on the current account CA is ambiguous.
Whether the current account improves or worsens depends on which effect of a real
exchange rate change is dominant—the volume effect of consumer spending shifts on
export and import quantities, or the value effect, which changes the domestic output equivalent
of a given volume of foreign imports. We assume for now that the volume effect of a
real exchange rate change always outweighs the value effect, so that, other things equal, a
real depreciation of the currency improves the current account and a real appreciation of
the currency worsens the current account.4
While we have couched our discussion of real exchange rates and the current account in
terms of consumers’ responses, producers’ responses are just as important and work in much
the same way. When a country’s currency depreciates in real terms, foreign firms will find that
the country can supply intermediate production inputs more cheaply. These effects have become
stronger as a result of the increasing tendency for multinational firms to locate different
stages of their production processes in a variety of countries. For example, the German auto
manufacturer BMW can shift production from Germany to its Spartanburg, South Carolina,
plant if a dollar depreciation lowers the relative cost of producing in the United States. The
production shift represents an increase in world demand for U.S. labor and output.
How Disposable Income Changes Affect the Current Account
The second factor influencing the current account is domestic disposable income. Since a
rise in Yd causes domestic consumers to increase their spending on all goods, including
EP*/P
EP*/P
EP*/P
EP*/P
3 The real exchange rate is being used here essentially as a convenient summary measure of the relative prices
of domestic against foreign products. A more exact (but much more complicated) analysis would work explicitly
with separate demand and supply functions for each country’s nontradables and tradables but would lead to
conclusions very much like those we reach below.
4 This assumption requires that import and export demands be relatively elastic with respect to the real exchange
rate. Appendix 2 to this chapter describes a precise mathematical condition, called the Marshall-Lerner condition,
under which the assumption in the text is valid. The appendix also examines empirical evidence on the time
horizon over which the Marshall-Lerner condition holds.
CHAPTER 17 Output and the Exchange Rate in the Short Run 425
TABLE 17-1 Factors Determining the Current Account
Change Effect on Current Account, CA
Real exchange rate, EP*/Pc CAc
Real exchange rate, EP*/PT CAT
Disposable income, Ydc CAT
Disposable income, YdT CAc
imports from abroad, an increase in disposable income worsens the current account, other
things equal. (An increase in has no effect on export demand because we are holding
foreign income constant and not allowing to affect it.)
Table 17-1 summarizes our discussion of how real exchange rate and disposable income
changes influence the domestic current account.
in an Open Economy
To analyze how output is determined in the short run when product prices are sticky, we
introduce the concept of aggregate demand for a country’s output. Aggregate demand is
the amount of a country’s goods and services demanded by households and firms throughout
the world. Just as the output of an individual good or service depends in part on the
demand for it, a country’s overall short-run output level depends on the aggregate demand
for its products. The economy is at full employment in the long run (by definition) because
wages and the price level eventually adjust to ensure full employment. In the long run,
domestic output therefore depends only on the available domestic supplies of factors of
production such as labor and capital. As we will see, however, these productive factors can
be over- or underemployed in the short run as a result of shifts in aggregate demand that
have not yet had their full long-run effects on prices.
In Chapter 13 we learned that an economy’s output is the sum of four types of expenditure
that generate national income: consumption, investment, government purchases, and the current
account. Correspondingly, aggregate demand for an open economy’s output is the sum of
consumption demand ( ), investment demand ( ), government demand ( ), and net export
demand, that is, the current account (CA). Each of these components of aggregate demand
depends on various factors. In this section we examine the factors that determine consumption
demand and the current account. We discuss government demand later in this chapter
when we examine the effects of fiscal policy; for now, we assume that is given. To avoid
complicating our model, we also assume that investment demand is given. The determinants
of investment demand are incorporated into the model in the Online Appendix to this chapter.
Determinants of Consumption Demand
In this chapter we view the amount a country’s residents wish to consume as depending on
disposable income, (that is, national income less taxes, ).1 ( , and are all
measured in terms of domestic output units.) With this assumption, a country’s desired
consumption level can be written as a function of disposable income:
C = C(Yd).
Yd Y - T C, Y T
G
C I G
CHAPTER 17 Output and the Exchange Rate in the Short Run 423
Because each consumer naturally demands more goods and services as his or her real
income rises, we expect consumption to increase as disposable income increases at the
aggregate level, too. Thus, consumption demand and disposable income are positively
related. However, when disposable income rises, consumption demand generally rises by
less because part of the income increase is saved.
Determinants of the Current Account
The current account balance, viewed as the demand for a country’s exports less that
country’s own demand for imports, is determined by two main factors: the domestic currency’s
real exchange rate against foreign currency (that is, the price of a typical foreign
expenditure basket in terms of domestic expenditure baskets) and domestic disposable
income. (In reality, a country’s current account depends on many other factors, such as
the level of foreign expenditure, but for now we regard these other factors as being held
constant.)2
We express a country’s current account balance as a function of its currency’s real
exchange rate, , and of domestic disposable income, :
As a reminder of the last chapter’s discussion, note that the domestic currency prices of
representative foreign and domestic expenditure baskets are, respectively, and ,
where (the nominal exchange rate) is the price of foreign currency in terms of domestic
currency, is the foreign price level, and is the home price level. The real exchange
rate , defined as the price of the foreign basket in terms of the domestic one, is therefore
. If, for example, the representative basket of European goods and services costs
the representative U.S. basket costs $50 ( ), and the dollar/euro exchange rate
is $1.10 per euro ( ), then the price of the European basket in terms of U.S. baskets is
Real exchange rate changes affect the current account because they reflect changes in
the prices of domestic goods and services relative to foreign goods and services. Disposable
income affects the current account through its effect on total spending by domestic consumers.
To understand how these real exchange rate and disposable income effects work, it
is helpful to look separately at the demand for a country’s exports, EX, and the demand for
imports by the country’s residents, IM. As we saw in Chapter 13, the current account is
related to exports and imports by the identity
when CA, EX, and IM all are measured in terms of domestic output.
CA = EX - IM,
= 0.88 U.S. baskets/European basket.
EP*/P =
(1.10 $/€) * (40 €/ European basket)
(50 $/U.S. basket)
E
€40 (P*), P
EP*/P
q
P* P
E
EP* P
CA = CA(EP*/P, Yd).
q = EP*/P Yd
2 In Chapter 19 we study a two-country framework that takes account of how events in the domestic economy
affect foreign output and how these changes in foreign output, in turn, feed back to the domestic economy. As the
previous footnote observed, we are ignoring a number of factors (such as wealth and interest rates) that affect
consumption along with disposable income. Since some part of any consumption change goes into imports, these
omitted determinants of consumption also help to determine the current account. Following the convention of
Chapter 13, we are also ignoring unilateral transfers in analyzing the current account balance.
424 PART THREE Exchange Rates and Open-Economy Macroeconomics
How Real Exchange Rate Changes Affect the Current Account
You will recall that a representative domestic expenditure basket includes some imported
products but places a relatively heavier weight on goods and services produced domestically.
At the same time, the representative foreign basket is skewed toward goods and
services produced in the foreign country. Thus a rise in the price of the foreign basket in
terms of domestic baskets, say, will be associated with a rise in the relative price of foreign
output in general relative to domestic output.3
To determine how such a change in the relative price of national outputs affects the current
account, other things equal, we must ask how it affects both EX and IM. When rises,
for example, foreign products have become more expensive relative to domestic products:
Each unit of domestic output now purchases fewer units of foreign output. Foreign consumers
will respond to this price shift by demanding more of our exports. This response by foreigners
will therefore raise EX and will tend to improve the domestic country’s current account.
The effect of the same real exchange rate increase on IM is more complicated. Domestic
consumers respond to the price shift by purchasing fewer units of the more expensive foreign
products. Their response does not imply, however, that IM must fall, because IM
denotes the value of imports measured in terms of domestic output, not the volume of foreign
products imported. Since a rise in tends to raise the value of each unit of
imports in terms of domestic output units, imports measured in domestic output units may
rise as a result of a rise in even if imports decline when measured in foreign output
units. IM can therefore rise or fall when rises, so the effect of a real exchange rate
change on the current account CA is ambiguous.
Whether the current account improves or worsens depends on which effect of a real
exchange rate change is dominant—the volume effect of consumer spending shifts on
export and import quantities, or the value effect, which changes the domestic output equivalent
of a given volume of foreign imports. We assume for now that the volume effect of a
real exchange rate change always outweighs the value effect, so that, other things equal, a
real depreciation of the currency improves the current account and a real appreciation of
the currency worsens the current account.4
While we have couched our discussion of real exchange rates and the current account in
terms of consumers’ responses, producers’ responses are just as important and work in much
the same way. When a country’s currency depreciates in real terms, foreign firms will find that
the country can supply intermediate production inputs more cheaply. These effects have become
stronger as a result of the increasing tendency for multinational firms to locate different
stages of their production processes in a variety of countries. For example, the German auto
manufacturer BMW can shift production from Germany to its Spartanburg, South Carolina,
plant if a dollar depreciation lowers the relative cost of producing in the United States. The
production shift represents an increase in world demand for U.S. labor and output.
How Disposable Income Changes Affect the Current Account
The second factor influencing the current account is domestic disposable income. Since a
rise in Yd causes domestic consumers to increase their spending on all goods, including
EP*/P
EP*/P
EP*/P
EP*/P
3 The real exchange rate is being used here essentially as a convenient summary measure of the relative prices
of domestic against foreign products. A more exact (but much more complicated) analysis would work explicitly
with separate demand and supply functions for each country’s nontradables and tradables but would lead to
conclusions very much like those we reach below.
4 This assumption requires that import and export demands be relatively elastic with respect to the real exchange
rate. Appendix 2 to this chapter describes a precise mathematical condition, called the Marshall-Lerner condition,
under which the assumption in the text is valid. The appendix also examines empirical evidence on the time
horizon over which the Marshall-Lerner condition holds.
CHAPTER 17 Output and the Exchange Rate in the Short Run 425
TABLE 17-1 Factors Determining the Current Account
Change Effect on Current Account, CA
Real exchange rate, EP*/Pc CAc
Real exchange rate, EP*/PT CAT
Disposable income, Ydc CAT
Disposable income, YdT CAc
imports from abroad, an increase in disposable income worsens the current account, other
things equal. (An increase in has no effect on export demand because we are holding
foreign income constant and not allowing to affect it.)
Table 17-1 summarizes our discussion of how real exchange rate and disposable income
changes influence the domestic current account.
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